Federal Reserve Weighs In on CRE

Testimony of Patrick M. Parkinson, Director, Division of Banking Supervision and Regulation

Before the Congressional Oversight Panel, Washington, D.C.

February 4, 2011

Chairman Kaufman, members of the Congressional Oversight Panel, thank you for your invitation to discuss the current state of commercial real estate (CRE) finance and its relationship to the overall stability of the financial system. Since the panel published its report, Commercial Real Estate Losses and the Risk to Financial Stability, one year ago, the rate of deterioration in market and credit conditions has leveled off, and there are some early signs of price stabilization in a number of key markets. Nonetheless, CRE delinquencies and losses are expected to remain elevated for some time.

Weakness in real estate markets, both commercial and residential, continues to be a drag on overall growth in the economy. Construction of nonresidential structures continues to lag because of weak fundamentals in the sector, including high vacancy rates and low property values, factors that are unlikely to change in the near term. Similarly, new home construction is likely to be constrained by the continuing overhang of distressed and vacant homes.

CRE-related issues also present ongoing problems for the banking industry, particularly for community and regional banking organizations. Losses associated with CRE, particularly residential construction and land development lending, were the dominant reason for the high number of bank failures since the beginning of 2008, and further CRE-related bank failures are expected over the next few years.

Credit losses for bank CRE loans typically continue well past the trough of recessions, and we expect this pattern to continue in this cycle. Working through the large volume of troubled CRE loans will take time as banks go through the difficult process of loan workouts and loan restructurings. If done prudently and effectively, including allocating appropriate levels of reserves and capital, loan restructuring can reduce the ultimate losses to the banking system. In addition, proper restructuring can reduce the damage done to businesses and the economy by limiting the forced liquidation of commercial properties that would further depress prices.

While we expect significant ongoing CRE-related problems, it appears that worst-case scenarios are becoming increasingly unlikely. CRE portfolio loan concentrations are not a significant risk factor for systemically important financial institutions. Some systemically important financial institutions have substantial exposures to commercial mortgage-backed securities (CMBS) and to derivatives securities such as CRE collateralized debt obligations. However, risks in these areas have been reduced, as significant mark downs have already been taken on these securities. In addition, conditions in the CMBS market have been improving, with spreads tightening and some new deals coming to market. However, we see losses in CRE to be an ongoing negative factor in bank portfolios that will need to be worked through over the next several years.

Current Conditions in the Commercial Real Estate Market
As housing market conditions deteriorated sharply throughout 2007, CRE markets began to experience weakness. Broad CRE market conditions remained relatively healthy until the second half of 2008, when CRE performance metrics turned down rapidly as a result of severe financial market disruptions and accelerating job losses. Vacancy rates increased sharply, rental rates plummeted, and property sales and values declined substantially. The higher vacancy rates and declines in the values of existing properties placed particularly heavy pressure on construction and development projects, which depend on market conditions at the time of completion for absorption and thus repayment.

Underlying market fundamentals of CRE remain a significant concern, but they have shown some signs of stabilizing. For instance, vacancy rates on office, industrial, and retail properties have stopped increasing, although they remained at elevated levels at the end of 2010, ranging between 13 percent and more than 16 percent, depending upon the property type and location. These levels are, on average, 5 to 6 percentage points above levels experienced in 2007. The rate of decline in rental rates has also slowed. At the beginning of 2010, office and industrial rental rates were between 10 and 12 percent lower than a year earlier, on average, but declines had slowed to between 5 and 7 percent at an annual rate at the end of the year. Sales volume of CRE properties improved each quarter during 2010, accumulating to almost $135 billion for the year as a whole. ¹ This total is double the CRE property sales volume for all of 2009.

Recent readings from CRE price indexes indicate that the rate of price declines has slowed substantially. The NCREIF Transactions Based Index fell more than 36 percent from its peak in the second quarter of 2007 to the first quarter of 2010. In contrast, the index indicated that prices as of the third quarter of 2010 were only 0.2 percent lower than they were at the beginning of the year. However, the degree of price stabilization across different types of properties and locations is uneven. In particular, demand has been rebounding for well-occupied properties in top-tier markets, while less desirable properties in less favorable markets are still struggling from a lack of demand.

Concentrations of CRE Exposure on Bank Balance Sheets
At the end of the third quarter of 2010, approximately $3.2 trillion of outstanding debt was associated with CRE, including loans for multifamily properties. Of this amount, about one-half, or $1.6 trillion, was held on the balance sheets of commercial banks and thrifts. An additional $700 billion represented collateral for CMBS, and the remaining balance of $900 billion was held by a variety of investors, including pension funds, mutual funds, and life insurance companies. Outstanding CRE debt has contracted 6 percent from its peak in 2008, while outstanding CRE loans at banks have contracted by almost 12 percent. The majority of the decrease in bank loans was associated with reductions in construction and development loan balances, which were largely the result of foreclosures and charge-offs.

Despite the decline in aggregate CRE loans at commercial banks, many banks still have CRE loan concentrations, as defined in the 2007 "Interagency Guidance on Concentrations in Commercial Real Estate."² Banks are considered to have a CRE concentration when loans for construction, land development, and other land exceed 100 percent of risk-based capital or total CRE is greater than 300 percent of risk-based capital.³ By this definition, almost 1,200 commercial banks, or 18 percent of all banks, had CRE concentrations at the end of the third quarter of 2010. CRE concentrations have been the dominant factor in bank failures. Of the more than 300 commercial banks and thrifts that have failed since the beginning of 2008, more than three-fourths had CRE concentrations at year-end 2007.

Notably, CRE concentrations are not a significant issue at the largest banks. Among banks with total assets of $10 billion or more, 10 percent had CRE concentrations. In contrast, one-third of all banks with assets between $1 billion and $10 billion had CRE concentrations. For banks with less than $1 billion in assets, approximately 17 percent had CRE concentrations.

Credit Quality of Commercial Real Estate in Bank Portfolios
At the end of the third quarter of 2010, almost 10 percent of CRE loans in bank portfolios were considered delinquent, a three-fold increase since the end of 2007. ⁴ Not surprisingly, loan performance problems have been most striking for construction and development loans, especially for those that finance residential development. Almost 19 percent of all construction and development loans were considered delinquent at the end of the third quarter of last year.

During 2010, delinquency rates on construction and development loans began to improve slightly, falling 1 percent in the first three quarters of 2010. Additionally, delinquency rates on loans backed by existing nonfarm, nonresidential properties leveled off in 2010. Still, even if CRE delinquency metrics continue improving, there remains a sufficiently large overhang of distressed CRE at commercial banks such that loss rates for this portfolio will likely stay high for some time and many banks with CRE concentrations will remain under stress.


Approximately one-third of all CRE loans (both bank and non-bank), totaling more than $1 trillion, are scheduled to mature over the next two years. This circumstance represents substantial refinancing risk as CRE loans typically have large balloon payments due at maturity. Banks have been dealing with maturing loans in a variety of ways, including providing extensions of performing assets, troubled debt restructurings, equity injections, collateral sales, and, in some cases, pursuing foreclosures. Since the issuance of the October 2009 supervisory guidance on prudent loan workouts, banks have significantly increased the level of restructuring of CRE loans.⁵ Economic incentives to restructure or refinance existing loans are aided by the current low interest rate environment. Some banks with properties in healthier markets are also beginning to see a pick-up in investor demand for high-quality properties with strong tenants.

Since the beginning of 2008 through the third quarter of 2010, commercial banks have incurred almost $80 billion of losses related to CRE exposure, equating to a little over 5 percent of the average exposure outstanding during this time. In past cycles, CRE credit and market fundamentals generally lagged the larger economy by a year or more. Given this historical experience and the recent improvement witnessed in the broader economy, it is estimated that banks have taken roughly 40 to 50 percent of the CRE losses that they will realize over this cycle. Using past cycles as a guide, we expect that the remaining losses will likely be incurred over the next few years.


While we can project potential losses facing banks, losses ultimately realized through this cycle will depend on the pace of improvement in the labor market, overall credit availability, and other macroeconomic and financial factors, especially unemployment rates and interest rates. Those factors are why we continue to emphasize the importance of stress testing as a critical element of managing risks associated with CRE concentrations.

Federal Reserve Supervisory Approach to Commercial Real Estate Concentrations
As noted in our previous statement to the panel on CRE conditions, the Federal Reserve led an interagency effort to develop supervisory guidance on CRE concentrations that was finalized in 2006 and published in the Federal Register in early 2007. ⁶ In that guidance, we outlined our expectations that institutions with concentrations in CRE lending need to perform ongoing assessments to identify and manage concentrations through stress testing and similar exercises to identify the impact of adverse market conditions on earnings and capital.

Since the quality of CRE loans at supervised banking organizations began to weaken, the Federal Reserve has devoted significant additional resources to assessing the quality of CRE portfolios. These efforts include monitoring the impact of changing cash flows and collateral values, as well as assessing the extent to which banks have been complying with our CRE guidance. Examiners have taken a balanced approach to ensuring that banks are recognizing losses in a timely manner, maintaining sufficient loan loss reserves, and monitoring collateral values while being mindful not to discourage healthy banks from making loans available to creditworthy borrowers.

Additionally, in an effort to encourage prudent CRE loan workouts, especially among maturing loans, the Federal Reserve led the development of interagency guidance issued in October 2009 regarding CRE loan restructurings and workouts.⁷ To better understand the effectiveness of this guidance, the agencies conducted a survey of financial institutions during their examinations. The survey was completed in the third quarter of 2010.

The survey was designed to gain an understanding of the current trends in the institution's CRE portfolios and an estimation of the volume of loan restructurings that are likely to occur within the next year. The majority of respondents described the quality of their CRE portfolios as relatively stable but expressed concern regarding borrowers' deteriorating repayment abilities and declining collateral values, which were of particular concern where maturing loans no longer met the institution's underwriting standards. Approximately two-thirds of the respondents were engaged in workout activity. Of note, respondents reported that almost three-fourths of loan modifications were performing according to their modified terms. The survey also noted that the volume of future CRE workouts was estimated to increase by approximately 60 percent during 2011. In contrast, banks have only restructured approximately 5 percent of all outstanding CRE portfolios to date.
Given the level of restructured loans to date and the estimated volume of future restructurings, the Federal Reserve will continue to review institutions' restructuring policies to ensure that modifications are pursued in a prudent manner. Moreover, examiners will also monitor banks' internal reporting systems to determine if restructured loans are performing in accordance with modified terms.

Regulated institutions continue to face significant challenges in determining the value of real estate in the current environment. For this reason, the Federal Reserve and the other federal banking agencies issued revisions to the Interagency Appraisal and Evaluation Guidelines in December 2010.⁸ The Federal Reserve expects institutions to have policies and procedures for obtaining new or updated appraisals as part of their ongoing credit reviews. An institution should have appraisals or other market information that provide appropriate analysis of the market value of the real estate collateral and reflect relevant market conditions, the property's current "asis" condition, and reasonable assumptions and conclusions.

Changes to Supervision at the Federal Reserve
To improve both the Federal Reserve's consolidated supervision and our ability to identify potential risks to the financial system, we have made substantial changes to our supervisory framework. We have augmented our traditional supervisory approach, which focuses on examinations of individual firms, with greater use of horizontal reviews, which simultaneously examine portfolios across a group of firms, to identify common sources of risks and best practices for managing those risks. To supplement information from examiners in the field, we have enhanced our quantitative surveillance program to use data analysis and formal modeling to help identify vulnerabilities at both the firm level and for the financial sector as a whole. This analysis is supported by the collection of more timely, detailed, and consistent data from regulated firms. Many of these changes draw on the 2009 Supervisory Capital Assessment Program, or SCAP.

Regarding CRE exposures specifically, we are working with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation on the collection of loan-level CRE data from a number of national and regional banks. The data collected will provide critical information on the credit quality and performance of these loan portfolios. These data will aid in the development of more forward-looking loan loss projections that will provide a useful benchmark for the broader CRE market that can be used for all institutions. They will also be used to develop more accurate stress test parameters for CRE portfolios of banks that the Federal Reserve supervises. In addition, the agencies have made adjustments to the Consolidated Reports of Condition and Income, or the Call Report, filed quarterly by banks, to obtain more detailed information with respect to their CRE restructurings.


Conclusion
Over the past year, CRE market and credit conditions have shown signs of stabilization and, in some areas, modest signs of improvement. We are also seeing signs of price stabilization in a number of CRE markets. Nevertheless, while some directional metrics are improving, the CRE market is still distressed and the strength and pace of improvements remains uneven.

We expect that banks will continue to incur substantial additional CRE losses over the next two years and that many banks with CRE concentrations will continue to be under stress. While problems in the CRE market will be an ongoing concern for a number of banking organizations and a negative factor for economic growth and lending, we do not see CRE losses as a threat to systemically important financial institutions.

Progress on working through the overhang of distressed CRE will take time and will depend on banks taking strong steps to ensure that losses are recognized in a timely manner, that loan loss reserves and capital appropriately reflect risk, that loans are modified in a safe and sound manner, and that loans continue to be made available to creditworthy borrowers. To this end, the Federal Reserve will continue to work with lenders to ensure that bank management and supervisors take a balanced approach to ensuring safety and soundness and serving the credit needs of the community.

Patrick M. Parkinson, Director, Division of Banking Supervision and Regulation

 

Lawmakers Urge Treasury to Support The CRE Market

 

WASHINGTON - This week, Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, and Congressman Ken Calvert (R-CA), sent a bipartisan letter to Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke about the growing concerns that deteriorating conditions in the commercial real estate (CRE) market may threaten an economic recovery.

"The growing bubble in the commercial real estate industry has the potential to infect our economy and slow a recovery," said Chairman Kanjorski.  "In order to safeguard the businesses operating on Main Street and protect the millions of jobs depending on commercial real estate, the Treasury and the Federal Reserve now must take needed and urgent action to stave off a potentially devastating wave of commercial real estate foreclosures and bank losses." 

"I am deeply concerned about the health of our commercial real estate market and the stability of thousands of small businesses across the country," said Congressman Calvert.  "We must take the appropriate steps to ensure that our commercial real estate market does not experience a liquidity crisis that would further exacerbate our struggling economic situation." 

"A liquidity crisis in the commercial real estate market is hurting small business owners across the entire nation," said National Association of REALTORS President Vicki Cox Golder, owner of the commercial real estate company Cox & Associates in Tucson, Arizona.  "I join with all commercial property owners who applaud the efforts of Reps. Calvert and Kanjorski to resolve this problem and put small business owners back in business." 

Specifically, the letter asks regulators to take the following steps:

• Establish a clear method for measuring and evaluating the effectiveness of recent CRE loan modification guidance issued by the regulators.

• Institute metrics to more clearly differentiate performing versus non-performing loans as well as any other steps that provide lending institutions with more confidence in assessing CRE loans.

• Make clear public statements encouraging lenders to continue to make credit available for performing assets as a means of restoring confidence and long-term value in the CRE market.

The $6.7 trillion CRE sector supports 9 million American jobs.  If the conditions in the CRE market deteriorate further the negative effects will be significant and widespread, rippling not only through the CRE sector but also the broader economy.  More than $1.4 trillion in commercial mortgages will come due by 2013, and as much as 65% of those deals will have trouble getting refinanced according to recent analysis conducted by Deutsche Bank.  While the Federal Reserve and Treasury Department have acknowledged the ongoing CRE challenges, their actions have so far failed to ease growing concerns among economists and market participants. 

The text of Congressmen Kanjorski and Calvert's letter which is signed by an additional 77 Members of Congress to Secretary Geithner and Chairman Bernanke from February 1 follows: 

Dear Secretary Geithner and Chairman Bernanke:
As you know, the financial crisis continues to have a dampening effect throughout the credit markets.  The commercial real estate (CRE) market, in particular, continues to experience difficult credit accessibility conditions.  Moreover, the scarcity of credit in the $6.7 trillion CRE sector poses a dangerous threat to our financial system just as our economy has begun to show signs of recovery. 

Earlier this month real estate data provider Trepp announced that the delinquency rate for loans underlying commercial mortgage-backed securities (CMBS) ballooned 500 percent in 2009, surpassing 6 percent in December for the first time.  Additionally, the CMBS market has all but shut down over the past year making it more difficult for CRE owners to sell or refinance. 

We appreciate the acknowledgement by federal regulators of this situation in October, when the Board of Governors of the Federal Reserve System, along with the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the National Credit Union Administration, and the Office of Thrift Supervision, issued a policy statement advising financial institutions to extend and/or restructure loans backed by income-producing and/or development properties whenever possible in order to minimize losses as well as to stabilize overall asset values in the communities they serve. 

While the regulatory guidance is a relatively recent occurrence, we remain concerned by early indications that it may not yet be having the desired impact in stabilizing the CRE market. While some properties are in desperate need of modification due to the economic downturn, we are not convinced these loans are being serviced properly or in an efficient manner.  Of even more concern, anecdotal evidence suggests that regulators continue to encourage lenders to write down the value of performing loans, whose payments may well be current and, in some instance, even call the loan.  This further exacerbates the crisis by creating defaults in properties that were able to meet their debt servicing. 

To ensure the recent CRE loan modification guidance will have a positive and stabilizing effect, and to protect the broader economy from further disruptions, we urge you to establish a clear method for measuring and evaluating its effectiveness.  Furthermore, we encourage you to institute metrics to more clearly differentiate performing versus non-performing loans as well as any other steps that provide lending institutions with more confidence in assessing CRE loans.  We also call upon you to make clear public statements encouraging lenders to continue to make credit available for performing assets as a means of restoring confidence and long-term value in the CRE market. 

In sum, we strongly believe that regulators must take continued steps to mitigate ongoing turmoil in the CRE sector before it becomes a full-fledged crisis, forestalls our economic recovery, and possibly requires additional taxpayer-funded capital injections.  Consistent with all applicable law and regulation, thank you for the consideration of our views and your attention to these matters.

### 

source http://kanjorski.house.gov/

Commercial Real Estate & Loan Modification News

Stuyvesant Town/Peter Cooper Village apartment complex misses loan payment - Reuters

Commercial Mortgage Delinquencies Spike, But There Is Hope - Wall Street Journal

A bottom in CRE?

Recently, talking heads on CNBC and elsewhere have been calling a bottom in CRE.  I am not so sure.  See this article by CNBC's Diana Olick.

Here are some numbers we reported yesterday from Trepp, a leading provider of CMBS and commercial mortgage information and analytics:

• Commercial MBS delinquencies rise 502 percent from a year ago to 6.07 percent.
• Hotel CMBS delinquencies jump 900 percent to nearly 14% of all loans in default.

Those are just a few ridiculous stats that I need to throw out to preface today's premise that commercial real estate is a buy.

Am I nuts?

No. Look, there is definitely going to be more pain before we see any gain, but after two interviews today, I started to think that maybe it's not all blood and guts in the market.

"We have seen a trend that keeps ticking upward, and we currently do not see a reason to say that that has plateaued, so we don't think the other shoe has ropped yet," says Trepp CEO Annemarie Dicola. But on the flip side, she adds, the investors are circling. "We find that a lot of our users are combing through the data looking for some interesting distressed opportunities, to try to find the overvalued properties that maybe now should be revalued and invested in."

We already know that Harry Macklowe is jumping back in to the lot vacated by the old Drake Hotel in Manhattan. Also, Blackstone Group is going after Highland Hospitality, a lodging REIT, despite the nasty numbers I wrote above. Why? There is activity, especially in the office sector.

 "There's a significant increase in the velocity of leasing, and by velocity I mean the number of square feet leased on a monthly basis," says Steve Siegel, Global Brokerage Chairman at CB Richard Ellis. "New York, for example, the first five months January through May we had an average of 900,000 square feet leased and from June until the end of December we had 1.8 million, so roughly a 100 percent increase per month."

There is also more activity in retail, of course depending on where you are. If you add the fact that commercial real estate construction has ground to a halt, and there is not the oversupply in commercial that there is in residential, you also see the positives. I'm also told lenders are working harder to save some of the delinquent loans, which Dicola calls a "green shoot." And that's making investors' ears perk up.

"What we have seen at trepp absolutely is a lot of new entrance to the CMBS market, a lot of investor groups that have been forming, circling and studying a lot of the data, and we see a lot of preparation for investor activity in this market," says Dicola. She cites three successful CMBS offerings at the end of 2009 after an 18 month drought. Investors have built up cash, and "volatility has now created a market for them.

Further declines in commercial real estate forcast by Moody's

Moody's said in a press release last week that commercial real estate will continue to decline in value before a long term stabilization occurs and the market begins to recover.  The income stream produced by commercial real estate which has been sold to investors as CMBS will not recover soon causing further declines in CMBS values.  Maturing CRE loans in these pools will not be able to be refinanced as maturities of bubble value loans approach.

The rating agency says that they will be downgrading CMBS tranches that were issued as late as 2008 - well into the bubble deflation.  They went on to say that the cash flows for properties with short-term lease structures, such as hotels and multifamily, will likely hit bottom in 2010 or early 2011. The bottom for office, retail and industrial properties will take longer to form.

Moody's says that property values have deflated 42.9% from their peak and thinks that the bottom will hit in up to two years from now at a 45-55% decline from the peak.

Source: http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_190851

Government Gives The Green Light To Pretend and Extend

Last week government bank regulators officially put their blessing on the practice of "pretending and extending" by issuing guidance to banks that allow them to modify commercial loans without being viewed unfavorably by their regulators. It has become clear to Washington that the next banking crisis and government bailout is right around the corner. They have taken this step to ease the pain that is sure to come.

Analyst estimate that there is about $270 billion in negative equity that has to be resolved in the next few years. This comes from about 1.5 trillion in debt that is maturing on CRE loans. This property can not be refinanced because of the negative equity. If the banks were to foreclose and not modify the loans, they would be forced to show the real value of the property on their books, wiping out the profits they reported earlier this year and causing a liquidity crisis in an already overstressed banking system.

By allowing the banks to modify these loans, the bankers and property owners are allowed to "kick-the-can" down the road some more years.

Prior to this change in guidance, if a bank were to modify a loan, and the loan amount was greater than the market value, the loan would have been considered "adversely credit classified". Such a loan modification wold not have been considered prudent based on sound banking principles. This new guidance allows them to modify the loans even if the loan amount exceeds the market value.

Property owners ought to contact their bank or a professional that specializes in commercial loan modification.

A New Paradigm For Commercial Real Estate Financing?

By Ted Schmidt

Commercial real estate is financed primarily through three channels, portfolio lending, commercial mortgage backed securities (CMBS) and direct cash purchases.

Portfolio lenders are regional banks, insurance companies, pension funds and others that lend money directly to commercial property owners. These loans stay on the lenders books for the life of the loans. Portfolio lenders have pulled out of the market and are actively trying to reduce their exposure to commercial real estate.

CMBS loans are made by mortgage banks that fund the initial transaction and then sell the income stream that the loan produces as investment vehicles on the stock market. The CMBS market seized up in 2008 following the sub-prime crisis and even with efforts from the Federal Reserve with the Term Asset Lending Facility (TALF) program to "prime the pump" the market is still effectively locked down. The TALF program allows institutional owners of CMBS to use the securities as collateral for extraordinarily low interest rates loans. This was designed to grease the wheels of the CMBS market but does not address the nearly $270 bn. capital deficiency on the exiting $800 bn. in maturing loans in the next 2 years.

Effectively there is nowhere to go. The options for both borrower and lender are few. Fed Chairman Ben Bernake says that these loans "ought to" be modified. Portfolio loans have some chance of being worked out and restructured since it is easy to identify and contact the owner. The major obstacle for regional banks who own these loans is that if they modify the loan or accept a short sale, they have to recognize the loss on their books. At a time when they are already hurting for capital they are reluctant to acknowledge the loss and would rather keep it on their books at full value. CMBS's cannot be modified because IRS rules that would render invalid the mortgage conduits tax exempt status. (these rules were changed 09-16-09)

Commercial property buyers remain on the sidelines as values plummet. Property owners and portfolio lenders are in still in denial about the true market value and can only sell at distressed prices. Right now, only seller financing and all cash deals are being accomplished in the commercial real estate space. Property owners are seeking commercial loan modification alternatives.

We need an entirely new way to fund commercial real estate transactions. Will the government step in with a commercial real estate bailout? Who will they bail out? Will congress pass new laws that will circumvent servicing agreements and force investors to accept renegotiated terms? These questions need to be answered.

We need a new paradigm in commercial lending. Comments please.